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Europe's debt crisis rears its ugly head

After going dormant for a few months, the debt crisis in Europe has returned to the fore.

NEW YORK (CNNMoney) -- If you thought the debt crisis in Europe was over, think again.

The nearly three-year old crisis appears to be entering a new phase as the respite in global financial markets, which came after the European Central Bank flooded the banking system with cash, has faded.

The focus has once again shifted to politics, long a source of agita for investors, with elections in several key nations set to change the balance of power in the eurozone.

As the economy slides toward recession, there is renewed debate over the wisdom of austerity, which Germany has made a priority, versus policies aimed at boosting growth.

This debate could decide the outcome of elections in France, Greece and now possibly the Netherlands. It could also determine the fate of Portugal, Spain and Italy, which are all struggling to regain credibility in the bond market.

"The emergence of these new coalitions will make crisis management more acrimonious," wrote Eurasia Group analysts in a note.

After Greece, investors see Portugal as the most likely candidate for another bailout.

Portugal's borrowing costs shot higher earlier this year amid fears the nation could seek to restructure its debts. Investors were also rattled after Standard & Poor's downgraded Lisbon's credit rating to junk in January.

In its most recent review, the IMF said that Portugal was "broadly on track" with the €78 billion bailout program the nation tapped nearly a year ago.

While the Portuguese economy is comparatively small, the nation's woes have highlighted the challenges facing larger eurozone economies, such as Spain and Italy.

Spain recently disclosed that its 2011 budget deficit was much larger than expected and warned that the government may not meet its fiscal targets for 2012.

Prime Minister Mariano Rajoy, in power since December, has proposed a €27 billion austerity program. But the Spanish economy, which is suffering from high unemployment and problems in the banking sector tied to the real estate market, has slipped back into recession.

While the authorities say Spain can avoid a bailout, yields on Spanish bonds have risen sharply recently as investors fear the nation will require some sort of external support.

The concern is that if Spain needs to be bailed out, there will not be enough money left over to support Italy in the event that Monti's reforms fall short.

Monti, who was appointed after Silvio Berlusconi stepped down late last year, has also been pushing back against austerity and emphasizing the need to stimulate growth as Italy's economy has stagnated for years.

ECB's options are limited

The ECB stepped up its efforts to prevent a credit crisis late last year when it offered European banks unlimited access to cheap, long-term loans.

ECB president Mario Draghi has said the goal was to help banks struggling to fund themselves amid concerns about exposure to sovereign debt. But the flood of liquidity also appeared to help drive down borrowing costs for troubled eurozone governments.

There is speculation that the ECB could resume limited purchases of government debt under its controversial securities market program.

Some analysts have also suggested that the ECB could move to full-blown quantitative easing, a strategy used by the Federal Reserve, to help boost the economy.

However, such steps would violate the ECB's mandate, which is to maintain price stability, and the bank has already stepped way out of its comfort zone. In addition, intervening in the bond market raises thorny questions of "moral hazard."

Instead, Draghi has stressed that governments must push ahead with fiscal consolidation and reforms to increase economic competitiveness.